Updated: Jun 12, 2020
While it is an undeniable fact that investing involves risk, most people don’t have a clear grasp of what risks are involved when investing in the stock market.
There are four risks that anyone investing in the stock market needs to understand and learn to manage.
The risk of losing your money.
Let's review each of these risks and discuss a simple strategy to manage each risk.
Risk 1: Losing all your money.
The most devastating risk of investing in the stock market is the possibility that you lose all your money. You take your hard-earned money, invest in a stock and then that stock’s price goes to zero and you lose all of your money.
Losing all of your money is a risk when you invest in individual stocks. It is one of the many reasons that investing in individual stocks is a bad idea.
The risk of losing all your money can be easily managed through properly diversifying in low-cost, l index funds. These are funds that track the returns of an entire stock market.
Index funds, provide wide diversification to a specific countries stock market.
If you invest in an S&P 500, your investment is spread over 505 large-cap U.S Stocks. For you to lose all of your money investing in an S&P 500 index fund, the United States would have to experience a complete economic collapse.
When investing in an S&P 500 index fund, there is still the risk that the U.S economy and stock market might not perform as well in the future as it has in the past. You are essentially putting all of your eggs in one basket, the U.S economy.
However, this is another risk that can be managed through further diversification. It is possible to invest in index funds that track the global stock market, not just a specific country. If you own every stock in the world, it does not matter which country has the best stock returns moving forward, you will still benefit.
The risk of an index investor losing all of their money is very low.
Risk 2: Uncompensated risk
There are two types of risk when investing in the stock market.
The simplest explanation of investment risk is that you are not guaranteed to have a positive return on investment. No result is guaranteed when you invest.
The risk of investing in the stock market is compensated. Investors are compensated for taking on investment risk with higher expected returns than risk-free assets.
There are also uncompensated risks. When you increase the risk in your portfolio without increasing your expected return, you are taking an uncompensated risk.
Investing in an individual stock or even a sector of the economy such as tech-stocks is an uncompensated risk.
By investing in low-cost index funds you can restrict your risk to compensated risk.
Risk 3: Volatility
When you invest in the stock market you are going to experience volatility, there is no way around that fact. Volatility means that stock prices can have very large upward and downward swings. If you have ever ridden a roller coaster, you know what volatility feels like.
While it’s not fun watching the stock market plunge, volatility is not a risk for all investors. If you have the discipline and patience to wait for stock prices to recover, volatility may not impact your long term wealth.
To determine if volatility is a risk, ask yourself two questions.
What is my investing time horizon?
Do I have the stomach to watch my investment drop by more than 50% in a single year?
If you are investing money you will not need for several decades and have the stomach to withstand market downturns, volatility may not be much of a risk.
If you will need the money you have invested in the short term or may not have the stomach to hold your positions during a downturn, volatility is a major risk when investing in the stock market.
Risk 4: Trying to avoid risk
Many people think they can avoid risk by not investing in the stock market. Let me be clear, there is no way to avoid risk. By not investing in the stock market you are simply trading in investment risk for inflation risk.
To understand inflation risk consider the difference between nominal and real returns.
Nominal returns do not account for inflation.
Real returns are equal to nominal returns minus inflation. If the nominal return of investment was 7% and inflation was 2% the real return was only 5%.
To understand why avoiding risk is risker in the long run lets uses an example.
Let’s say you have $100,000 in cash that you want to save and you were considering two options.
Option 1: Invest in the stock market with expected returns of 7% per year.
Option 2: Save your money in a savings account and earn 2% interest per year.
After 30 years.
You would expect to have $811,650 if you invested in the stock market.
You would have $182,121 if you kept your money in a risk-free savings account.
These are only your nominal returns. Let’s look at the expected real returns, assuming 2% inflation each year.
You would expect to have $446,774 if you invested in the stock market.
You would have $100,000 if you in the risk-free savings account.
Inflation has eaten away all of the interest you earned in the risk-free savings account.
To avoid the “risk” of investing, you would have given up $336,774. To make up for this shortfall, you would have to either postpone retirement by many years or reduce your lifestyle in retirement.
Over the long term, the greatest risk you can take is not taking any risk at all.
There is no free lunch. Whether we choose to invest in the stock market or stick our money under our mattress we are taking on risk. All we are doing is trading one type of risk for another.
Investors face four types of risk.
Losing all your money.
All of these risks can be managed by investing for the long-term in low-cost index funds.
The diversification of index funds greatly reduce the risk of losing all your money
By tracking the stock market, index funds expose you to compensated risks and avoid uncompensated risks
.If you are a long term index investor, volatility is unpleasant but only a risk if you make emotional investment decisions.
By providing positive real expected returns, index investing shields you from the risk of inflation eating away the real value of your investment.
What do you think, are their other risk categories I’ve neglected? Have you found research that suggests there are better ways to manage the four risks discussed in this article? Let me know in the comments.
This article is for informational purposes only not all information will be accurate. This should not be considered Financial or Legal Advice. Consult a financial professional before making any major financial decisions.